In financial analysis, ratio is used as an index of yardstick for evaluating the financial position and performance of the firm. It is a technique of analysis and interpretation of financial statements. Ratio analysis helps in making decisions as it helps establishing relationship between various ratios and interpret thereon. Ratio analysis helps analysts to make quantitative judgement about the financial position and performance of the firm. Ratio analysis involves following steps:
1. Relevant data selection from the financial statements related to the objectives of the analysis.
2. Calculation of required ratios from the data and presenting them either in pure ratio form or in percentage.
3. Comparison of derived different ratios with:
i. The ratio of the same concern over a period of years to know upward or downward trend or static position to help in estimating the future, or
ii. The ratios of another firm in same line, or
iii. The ratios of projected financial statements, or
iv. The ratios of industry average, or
v. The predetermined standards, or
vi. The ratios between the departments of the same concern assessing either the financial position or the profitability or both.
4. Interpretation of the ratio
Ratio analysis uses financial report and data and summarizes the key relationship in order to appraise financial performance. The effectiveness will be greatly improved when trends are identified, comparative ratios are available and inter-related ratios are prepared.